There’s a common misconception that Social Security benefits are tax-free. In fact, many people pay federal tax on a portion of their benefits.

Recent inflation has resulted in a record 8.7% cost-of-living adjustment to Social Security benefits for 2023. But the tax brackets used to determine how much of your benefits are taxable aren’t adjusted for inflation. This means that some Social Security recipients will see their tax bills increase this year. The good news is that there are strategies available to minimize these taxes. But first, let’s discuss how Social Security benefits are taxed.

Federal taxation of benefits

The portion of your benefits that’s taxable depends on your combined, or “provisional,” income. It’s equal to your adjusted gross income (AGI) from sources other than Social Security, plus any nontaxable interest you receive, plus one-half of your Social Security benefits. Thus:

  • If your combined income is less than $25,000 ($32,000 for joint filers), then your Social Security benefits aren’t taxable.
  • If your combined income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), then up to 50% of your benefits are taxable.
  • If your combined income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.

Suppose, for example, that Carol is a retiree who files her federal tax return as an individual and that her annual Social Security benefits total $36,000. If her AGI is $30,000 (and assuming she receives no nontaxable interest), then her combined income is $48,000 ($30,000 plus one half of $36,000). That means up to 85% of her Social Security benefits, or $30,600, is taxable.

Tips to ease the tax bite

The key to reducing tax on Social Security benefits is minimizing your combined income. One way is to put off claiming Social Security for as long as possible — until age 70 — which also maximizes the amount of your benefits.

During your 60s, consider taking withdrawals from IRAs or other tax-deferred accounts, spreading them out to minimize the tax hit in any given year. That way, by the time you reach your 70s, you’ll have reduced your balances in tax-deferred accounts, thereby reducing your required minimum distributions and, in turn, your combined income.

Another strategy is to use a Roth IRA to save for retirement, or to convert traditional IRAs into Roth IRAs before you start taking Social Security benefits. Qualified withdrawals from Roth IRAs are tax-free and don’t count toward your combined income. Keep in mind that a Roth conversion will trigger immediate taxation of the converted amount, so it’s usually best to do the conversion gradually over several years to spread out the tax and avoid pushing yourself into a higher tax bracket.

Important: Most states don’t tax Social Security benefits, but some do. If you live in one of these states, consider the impact of state taxes as part of your planning efforts.

Have a plan

If you’re approaching retirement, consider the taxability of Social Security benefits. With some planning, you can minimize, or even avoid, those taxes. Your financial advisor can explain your options.

© 2023

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